KayCee Manufacturing Company paid a dividend yesterday of $3.50 per share.The dividend is expected to grow at a constant rate of 10% per year.The price of KayCee's common stock today is $40 per share.If KayCee decides to issue new common stock,flotation costs will equal $4.00 per share.Kaycee's marginal tax rate is 35%.Based on the above information,the cost of retained earnings is
A) 26.41%.
B) 20.09%.
C) 19.63%.
D) 17.55%.

Question

Quizplus · Accepted Answer

The cost of retained earnings is the rate of return required by the shareholders to invest in the company’s retained earnings. This can be calculated using the Gordon Growth Model formula:

Cost of Retained Earnings = (Dividend Yield + Dividend Growth Rate)

Dividend Yield = Dividend / Current Stock Price
= $3.50 / $40
= 0.0875 or 8.75%

Dividend Growth Rate = 10%

Therefore, the cost of retained earnings = (8.75% + 10%)
= 18.75%

However, we need to adjust for the flotation costs and taxes. Flotation costs are a one-time expense that reduces the amount of funds available to the company, while taxes reduce the after-tax cash flow available to the company. The adjusted cost of retained earnings can be calculated using the following formula:

Adjusted Cost of Retained Earnings = Cost of Retained Earnings / (1 - Flotation Costs) x (1 - Tax Rate)

= 18.75% / (1 - 0.040) x (1 - 0.35)
= 19.63%

Therefore, the cost of retained earnings for KayCee is 19.63%.

KayCee Manufacturing Company Paid a Dividend Yesterday of $3